Readers' comments

As many have argued, low foreign-currency debt is key. Prior to formation of euro area, no advanced economy had significant foreign-currency debt. Many emerging markets now have little or no foreign-currency debt which changes their response to exchange rates for the better.

The size and composition of trade has some effect on the magnitude of this relationship, but does not change the basic result.

The real test is unemployment and devaluation does work better when it is possible (Iceland, Denmark). The difficulty is when devaluation is not possible, as in lacking their own currency (Ireland, Greece), or possible only with great difficulty such as a lot foreign debt. Devaluation still works as debt is generally less than gdp but may involve default. The Baltics are avoiding this for political, not economic reasons, and are likely justified in this.

Iceland’s experience is interesting, and also misleading for the first sight: net foreign assets declined from minus 112% of GDP in 2007 to minus 629% of GDP in 2010. But most of the worsening is the liability of banks undergoing winding-up proceedings and therefore will never be paid back. See Tables 2 and 3 of my paper comparing the adjustments of Iceland, Ireland and Latvia:http://www.bruegel.org/download/parent/663-a-tale-of-three-countries-rec...
I also conclude that Icelandic adjustment was the least painful and fastest among these three countries.

That's a very useful paper; there's a couple of points I'd like to bring out:

- You note that deposits by non-residents were fully guaranteed by the government, so can you really say that most of the liability "will never be paid back"? How much of Iceland's future income is going to be consumed with meeting this guarantee?

- There was also a sharp drop in external assets, presumably related to the banking collapse as well. That's a loss of national income that would have to be made up somewhere else if they wanted to maintain their standard of living.

• Guaranteed deposits account for just a small part of bank liabilities, as banks largely borrowed from the wholesale market.

• The issue of deposits at late Icesave, the foreign branch of previous Lansdbanki, is a different one from the guaranteed deposits in Iceland. Jon Danielsson and Gylfi Zoega argued that the actual cost of Icesave may not be more than 2 percent of Icelandic GDP, since most of the costs will be covered by the recovery from the assets of Lansdbanki: http://www.voxeu.org/article/lessons-icesave-rejection

• Sharp drop in external assets: I am not sure. The Central Bank of Iceland has a nice chart on assets and liabilities of the main sectors - see Chart 7.4 on page 66 in this document: http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=8134 (unf we could not find an update of this document, nor the underlying data). The text argues that the private sector excluding financial institutions and pension funds had a positive net external debt position of 6.5% of GDP at the end of 2009.

Let me also respond to another point you made earlier: the 44% fall in gross national income of Iceland. That is measured in US dollars – when the currency collapses, it is not surprising that everything which is generated in domestic currency falls sharply in dollars. GDP and GNI measured in constant price domestic currency, as well as employment, are more meaningful indicators of the economic costs of the adjustment.

We contacted the Central Bank of Iceland (CBI) for specific info and got a response today.

* Deposits: in June 2008 deposits of domestic residents were 1372bn, while deposits of non-residents in Iceland were only 95bn. And as I said earlier, banks funded themselves mostly from the wholesale market so the guarantee of these non-resident deposits in Iceland is indeed a minor issue. (Deposits of non-residents in branches of Icelandic banks abroad, ie Icesave, is different issue, but see my earlier comment on this.)

So thanks again for your comments, both are well made, but quantitatively they are not important and therefore does not change my conclusion that the Icelandic policy mix was better than the Latvian and the Irish policy choices.

As I've pointed out at least once before here, it's the balance sheet effects that are the constraining factor. Any European country that takes the devaluation route - such as Greece might, and Iceland did - will be left with a huge burden of foreign-currency debt, and can look forward to many years of working harder just to service that debt. Iceland's national disposable income - what's left after paying its foreign creditors - has been utterly blitzed since 2008, compared to say the Baltic states which didn't devalue.

The Australian example is irrelevant, since all of their external debt was local-currency denominated.

The problem with this debate remains that GDP is utterly the wrong measure to be using. Paul Krugman will always win the argument when you let him dictate the terms.

"• Greek trade deficit declines to close to zero due to a collapse in imports - but also higher exports.
• Since the IMF program began, unit labour costs have declined by almost as much as required by the program.
• And, relative to the EU average, labour costs in the private sector have declined 30% over the same timeframe."

I found this surprising, good news and evidence that adjustments can happen quickly (in say 3 years) even without devaluation. would be interested in your thoughts.

I am surprised by the 30% number on relative unit labour costs. In a paper I published yesterday:http://www.bruegel.org/download/parent/737-productivity-labour-cost-and-...
I looked at unit labour cost developments of 24 EU countries for various sectors of the economy
Greek ULC did not really decline much from the peak in 2010 till the end of 2011 in my preferred sector (the business sector excluding agriculture, construction and real estate activities) - see the chart on page 38 (bottom line, middle panel)
Relative to euro area partners there was some decline in ULC from 2010 to 2011, but the latest value (2011Q4) is quite similar to the early 2008 values (page 39, first line, right-hand panel), ie there is no indication of anything like a 30% decline
And Greek exports are performing poorly: the volume of exports of goods and services is about 18% below its 2008Q1 value, in contrast to eg Spain, Portugal and Ireland, where export volumes exceeded their 2008Q1 values by end-2011.
I wonder what kind of data was used by Goldman Sachs

Note that Australia is one of the world's most closed economies. It imports only a tiny proportion of GDP (15.7% of GDP in 2011 - and much less back at the turn of the century).

This is more because of natural transport costs than trade barriers - it just costs a lot to move goods & services to and around around a sparsely populated continent sized nation - so a higher proportion of the value added is inevitably local (i.e. retail & logistics mark ups dominate prices - insulating the economy from exchange rate movements).

In a nearly closed economy, devaluation can be relatively painless. Especially when oil prices (a massive portion of Australia's imports) crash at the same time ...

On the other hand, Spain is not a closed economy. Spanish imports & exports are approaching 30% of GDP each, with exports growing. Spain does not have massive logistics & retail mark ups on imported goods sold, and any depreciation would feed directly into immediate inflation.

RA
"Basically, the shock was a loss of export demand from Asia and a drying up of capital inflows. The Aussie depreciation enabled Australia to shift exports to other markets and keep on growing. It was not inflationary to any perceptible degree."
True. But why didn´t the same thing happen in New Zealand, which also experienced a devaluation?
The difference in outcomes in the two countries is accounted for by the different monetary policiesthey racticed.http://thefaintofheart.wordpress.com/2011/02/24/australia-does-it-better/

Not sure that Argentina and Australia--countries that derive the vast majority of their export income from basic resources--provide useful lessons to countries that are competing in the services and manufactured goods spaces. Adjustments that involve complex global supply chains and specialized human resource structures are bound to take a lot longer to bear fruit.

Agreed. As much as people keep looking for the all-encompassing rule, that devaluation is better than internal adjustment or vice versa, it completely depends on the idiosyncratic factors of that country. So, what might have worked in Australia or in Argentina will have little effect in, say Greece, or even the UK, whose composition of imports is largly highly inelastic energy.

This is a bogus claim. The question is not whether the Aussie dollar devalued against the US dollar, which will always rise in the midst of a financial crisis. The question is whether it devalued relative to the currencies of the country's major trading partners. Australia trades a lot with Japan, South Korea, and the ASEAN countries, all of which devalued their currencies by significant amount. The fact that inflation actually fell during that period tells you that there was no real depreciation.

Why not make a claim about the Swiss franc devaluing by 30% during the euro crisis too?

Without the numbers in front of me I can't say for sure, but I'd venture to guess that the calculation is skewed by oil import from APEC countries, whose currencies are pegged to the US dollar. Oil prices fell sharply as a result of the crisis, so the change did not result in an immediate jump in inflation. That would come later, when oil prices recovered.